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UtILItY WeeK | 19th - 25th September 2014 | 19 Finance & Investment Analysis W ater companies are not the only ones with their focus squarely on the outcome of Ofwat's price review. The outcome of PR14, once the final determinations are made, could shape which companies are the prime candidates for potential takeover bids. Those companies with a more generous final determination, and a business plan that has more potential for outperformance, and therefore a higher dividend return, will appeal to the money men. And those inves- tors – the pension funds, sovereign wealth funds, and international consortia – are beginning to give the water sector the eye once again. They would also have been encouraged to turn their attention back towards the UK's water sector aer Cathryn Ross, Ofwat's chief executive, suggested in April that the regula- tor would be open to allowing deals to take place. "We recognise that changes to indus- try structure may be appropriate," she said. "I don't have an industry blueprint that I'm working to, but I would be surprised if 18 vertically integrated water companies was the most appropriate structure." The last bid for a UK water company was made by the Long River consortium in what proved to be a fruitless pursuit of Severn Trent (see box). In June 2013 it had a £5.3 billion offer rejected by the board of Severn Trent, which at the time said the third and final offer from the consortium "failed to reflect the signifi- cant long-term value of Severn Trent or to recognise its future potential". However, this rejection is unlikely to have stifled the appetite of future bidders, not only for Severn Trent, but across the sector. Angelos Anastasiou, utilities analyst at Whitman-Howard, says there would be "some takeover potential in the water sector in the medium term" come 2015, when the final determinations have been made and accepted by the water companies. Stefanie Voelz, senior analyst at Moody's, agrees that once the PR14 determinations have been concluded "there might be inter- est because there are infrastructure funds out there looking for investments in sectors that are relatively stable and secure." While "M&A is clearly very much back on the cards", according to Stephen Hunt, ana- lyst at UBS, the potential targets for a takeo- ver bid are less clear. Severn Trent is an obvious candidate, given its history, but organising and find- ing the funds for the larger companies may prove more difficult. Hunt says: "We had the bid for Severn Trent last year and that would have been in nominal terms the biggest water M&A transaction in UK history. "United Utilities is a candidate for a potential takeover bid, but United Utilities is 20-25 per cent bigger than Severn Trent – that's an awful lot of capital." The most likely candidate among the bigger companies is Pennon, the parent company of South West Water, despite its continued ownership of Viridor. Hunt tells Utility Week that previously, Viridor had dis- couraged bidders because it did not have a stable income stream and "your typical infra- structure investors wouldn't want that expo- sure to a non-regulated waste business". However, as Viridor now has a stable income via its energy-from-waste business, the barrier has been significantly lowered. "It is now quite a realistic prospect that you could put together a consortium of pri- vate equity companies that may look at Pen- non overall and could easily split Viridor out from the group," says Hunt. Voelz is less convinced that Pennon is a likely takeover target, due to the Viridor question. She also thinks the large size of the listed water companies could itself serve as a barrier. "You would need to write a very large cheque, and it might be difficult to get the money together," she says. "It may be easier to get the capital together for the smaller water-only companies, but it depends on finding someone willing to sell." The smaller water-only companies may be a better target for investors who want to have a significant stake in their investment. Hunt explains: "If you're a £2 billion infrastructure fund, you would want to put no more than a quarter of your fund into a water asset. "If you're bidding for one of the bigger companies you're going to have such a small position and you're not going to have any voting power, yet it is such a huge part of your portfolio. That's why the smaller com- panies are more likely. It allows you to con- struct that consortium." Yet the issue with the smaller companies, especially those that will look attractive once the final determinations have been issued in December, is that the owners will want to hold on to them, with their stable return and high potential for overperformance. The last takeover bid – by Long River – was hard fought, and there is no reason to suppose that future bids will be any more warmly received. Takeovers after PR14? Ofwat has indicated a softening on its stance against takeovers, so once PR14 is settled, water companies could be joining cash-rich investors in sizing up the sector. Mathew Beech reports. The Severn Trent saga Last summer, the Long River consortium attempted to buy Severn Trent but ultimately failed. First bid (14 May 2013) £20.5 per share; £4.79 billion in total Second bid (31 May 2013) £21.25 per share; £4.96 billion in total Final bid (7 June 2013) £22 per share; £5.3 billion in total Jan Feb Mar Apr May Jun Jul Aug Sep 1960 1880 1800 1720 1640 Severn TrenT Share price, 2014